Income tax: Pay As You Go - withholding from payments to employees

This Ruling applies to entities that pay salary, wages, commission, bonuses or allowances to an individual as an employee (whether of the paying entity or another entity). The Ruling provides guidance as to whether an individual is paid as an employee for the purposes of section 12-35, Schedule 1, Part 2-5 Pay As You Go (PAYG) of the Taxation Administration Act 1953 (TAA) . That section imposes an obligation on the paying entity to withhold an amount from the relevant payment.

The PAYG system, contained in Schedule 1 to the TAA , is a comprehensive new system for the collection of income tax and other liabilities. Schedule 1, Part 2-5 of the TAA , relates specifically to the PAYG withholding provisions. These provisions replace the Prescribed Payments System (PPS) and the Reportable Payments System (RPS) and incorporate the main elements of the current Pay As You Earn (PAYE) system. The remaining withholding systems which cover various types of payments (eg. dividends, interest and royalties payments to non-residents) have also been standardised and form part of the new PAYG withholding regime.

Before PAYG, the income tax law had 9 systems under which amounts were required to be withheld from payments and remitted to the Commissioner. These systems included: PAYE; PPS; RPS; withholding where no Tax File Number (TFN) is quoted on investments; collection of withholding tax on dividends, interest and royalties paid to non-residents etc. Each of these systems had its own legislative structure with its own discrete set of machinery rules (i.e., rules in relation to the reporting and remission of these amounts to the Commissioner).

The new withholding provisions - the PAYG withholding provisions - provide a single set of common machinery rules applicable to all withholding payments. The PAYG withholding provisions have effect in relation to payments made on or after 1 July 2000.

Division 12 of Part 2-5 of Schedule 1 of the TAA contains the PAYG withholding provisions that apply to cash payments. Division 14 of Part 2-5 of Schedule 1 of the TAA, applies to non cash benefits. A non-cash benefit includes property or services in any form except money. Under these provisions, an entity (the payer) must pay an amount to the Commissioner before providing a non-cash benefit to another entity (the recipient) if they would have been required to withhold an amount had that payment been in the form of money. However, there is no requirement to pay an amount to the Commissioner if the benefit is: • a fringe benefit • an exempt benefit under the Fringe Benefits Tax Assessment Act 1986 , or • a benefit being the acquisition of a share or right under an employee share scheme within the meaning of Division 13A of Part III of the Income Tax Assessment Act 1936 (ITAA 36).

Section 10-5 of Schedule 1 of the TAA lists the 24 withholding payments to which PAYG obligations attach. (see Attachment A). Where the PAYG provisions refer to 'employees' the reference is to employees at common law. Paragraphs 21 and 22 of this Ruling provide a summary of who is a common law employee.

PAYG incorporates the main elements of the PAYE system. Payments under labour hire arrangements are now specifically covered and there is flexibility to specify other payments for work or services. In addition there are two new withholding events: • payments for work or services where businesses and workers voluntarily agree that withholding will occur from payments made; and • payments made in respect of a supply where the supplier has not provided their Australian Business Number (ABN) to the payer.

Section 12-35 of Schedule 1 of the TAA provides that An entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee (whether of that or another entity).

This Ruling is concerned with whether an entity has an obligation to withhold under section 12-35 of Schedule 1 of the TAA. For the purposes of the PAYG provisions, the definition of entity, takes its meaning from section 995-1 of the Income Tax Assessment Act 1997 (ITAA 97) . [F1] Under that provision, an entity is defined by section 960-100 of the ITAA 97 to mean an individual, body corporate, body politic, partnership, any other unincorporated association or body of persons, a trust, and a superannuation fund.

Section 12-35 of Schedule 1 of the TAA is subject to three general exceptions listed in section 12-1 of Schedule 1 of the TAA: • an entity need not withhold an amount from a payment made under section 12-35 of Schedule 1 of the TAA where the whole of the payment is exempt income of the entity receiving the payment; • in working out how much to withhold, the payer may disregard so much of the payment as is a living away from home allowance benefit as defined by section 136 of the Fringe Benefits Tax Assessment Act 1986 ; • in working out how much to withhold, the payer may disregard so much of the payment as is an expense payment benefit as defined by section 136 of the Fringe Benefits Tax Assessment Act 1986 and is not an exempt benefit by virtue of the operation of section 22 of that Act.

Section 12-35 of Schedule 1 of the TAA applies to payments made to individuals in their capacity as employees. It does not apply to payments made to partnerships, companies, or trustees - provided the arrangement is not a sham or a mere redirection of an employee's salary or wages.

A sham is an arrangement that creates the appearance of rights and obligations different from those actual rights and obligations that the parties intend to create. [F2] The parties must have a common intention that the arrangement is a mere facade, disguise or false front for a sham arrangement to exist. [F3]

Also, a payment to a third party is treated as a redirection of an employee's salary or wages (and hence a constructive payment of salary or wages to the employee) in circumstances where there is a subsisting employment contract that has not been terminated and the payments are attributable to services rendered by the employee - section 11-5 of Schedule 1 of the TAA.

Where a service company is used to provide the personal services of its principal, all the terms of the contract must be consistent with such an engagement. The contract must indicate an intention to contract with the service company rather than with the individual. In addition, any payments of salary or wages from the service company to its employees are subject to the PAYG system.

Alternatively, where personal services income is diverted through a company, partnership or trust to avoid the incidence of income tax, the general anti avoidance provision in Part IVA of the ITAA 36 may apply. Taxation Ruling IT 2121 outlines some instances where the Commissioner may invoke Part IVA of the ITAA 36. [F4]

The employment relationship does not necessarily have to be between the entity making the payment and the individual. Section 12-35 of Schedule 1 of the TAA provides that a withholding must be made from a payment of salary, wages, commission, bonuses or allowances paid to an individual as an employee of the payer or some other entity. The essential characteristic is the nature of the payment in the hands of the recipient. If it is a payment of salary, wages etc, a withholding obligation arises on the payer.

The relationship between an employer and an employee is a contractual one. It is often referred to as a contract of service (or, in the past, as a master/servant relationship). Such a relationship is typically contrasted with the independent contractor/principal relationship that, at law, is referred to as a contract for services . An independent contractor typically contracts to achieve a result whereas an employee contracts to provide his or her labour (typically to enable the employer to achieve a result). An independent contractor works in his or her own business (or on his or her own account) while an employee works in the service of the employer, i.e., in the employer's business.

At law there is a clear distinction between a contract for services (where the contractor is self-employed and works on his or her own account) and a contract of service (where the contractor is employed by the payer and works on account of, or in the business of, the payer). In most cases, the character of the contract is self-evident. However, it is sometimes difficult to discern the true character of a contract from the facts of the case as the intentions of the contracting parties may be unclear or ambiguous, such as where the terms of the contract are disputed or are otherwise in apparent conflict.

The arrangement between the parties may be structured in a way that does not give rise to a payment for services rendered but rather a payment for something entirely different, such as a lease or a bailment. In these circumstances, a person enters into a lease or bailment for the use of property owned by another person, and payments are made from the lessee or bailee to the lessor or bailor. Consequently, the lessee or bailee, rather than being a provider of services to the owner of the asset, acquires a right to exploit that asset for his or her own benefit in return for a 'rental' payment to the owner. In FCT v. De Luxe Red and Yellow Cabs Co-op (Trading) Society Ltd and Others , [F5] the Full Federal Court found that a bailment contract existed between the taxi licence owner and the taxi driver, which effectively precluded the existence of an employer/employee relationship.

Labour hire arrangements have also become an increasingly common way for businesses to engage labour. A labour hire arrangement is one where an end user of labour engages an individual to perform work or services through an intermediary (a labour hire firm). In practice, the labour hire firm contracts with the individual and pays the individual to provide the end user with work or services. Payments made by a labour hire business to its workers are also subject to PAYG withholding under a separate provision - section 12-60 of Schedule 1 of the TAA.

The common law meaning of the term 'employee' was stated by the High Court in Stevens v. Brodribb Sawmilling Company Pty Ltd . [F6] It is clear from that case that there is no single objective test which will give the answer: '... it is the totality of the relationship between the parties which must be considered ...'; [F7] and '... the question is one of degree for which there is no exclusive measure ...'. [F8]

While various features have been identified by the Courts as indicators of the true nature of the relationship, those features are only ever a guide to answering that question. It is necessary in each case to examine all the terms of the contract and to determine whether, on balance, the person is working in the service of another (i.e., as an employee) or is working on his or her own behalf (i.e., as an independent contractor).

Where there is a written contract, the express and implied terms of the contract provide evidence of the intention of the parties at the time of its formation. Those terms are identified and construed according to the circumstances surrounding the making of the contract. Conduct after formation of the contract is only relevant where it can be shown to amount to a modification of the original contract. [F9]

A clause in a contract that purports to characterise the relationship between the parties as that of principal and independent contractor and not that of employer and employee must be considered with all the other terms of the contract. Such a clause cannot receive effect according to its terms if it contradicts the effect of the agreement as a whole; the parties to an agreement cannot alter the true substance of the relationship by simply giving it a different label. As Gray J stated in Re Porter: re Transport Workers Union of Australia : [F10] 'Although the parties are free, as a matter of law, to choose the nature of the contract which they will make between themselves, their own characterisation of that contract will not be conclusive. A court will always look at all of the terms of the contract, to determine its true essence, and will not be bound by the express choice of the parties as to the label to be attached to it. As Mr Black put it in the present case, the parties cannot create something which has every feature of a rooster, but call it a duck and insist that everybody else recognise it as a duck.' However, the parties may use such a clause to overcome any ambiguity as to the true nature of the relationship. [F11]

For example, an employer may seek to change the status of an employee to that of independent contractor by both parties signing a contract of engagement that includes a clause to the effect that the worker is an independent contractor rather than an employee. That clause is ineffective if it is inconsistent with the apparent true nature of the relationship inferred from the contract as a whole. If the terms of the subsisting relationship (such as leave entitlements and other employee benefits) are not changed, it is likely that the worker's status would remain that of employee.

The circumstances surrounding the formation of the contract may assist in determining the true character of the contract. [F12] Thus, if a contract comes into existence because the contractor advertises his or her services to the public in the ordinary course of carrying on a business or as a result of a successful tender application, the existence of a principal/independent contractor relationship is inferred. Conversely, if the contract is formed in response to a job vacancy advertisement or through the services of a placement agency, the existence of an employer/employee relationship is inferred. [F13]

Bearing the above in mind, the features discussed below have traditionally been regarded by the Courts as key indicators of whether a contract is one of service or for services .

The classic 'test' for determining whether the relationship of 'master' and 'servant' existed was the exercise of control over the manner in which work was performed. With increasing usage of skilled labour and consequential reduction in supervisory functions, the focus of the control test has changed from the actual exercise of control to the right of control. Moreover, while control is important, it is not the sole indicator of whether or not a relationship is one of employment. [F14]

The mere fact that a contract may specify in detail how the contracted services are to be performed, does not necessarily imply an employment relationship. In fact, a high degree of direction and control is not uncommon in contracts for services. The payer has a right to specify how the contracted services are to be performed, but such control must be expressed in the terms of the contract otherwise the contractor is free to exercise his or her discretion (subject to any terms implied by law). This is because the contractor is working for himself or herself.

Under a contract of service, on the other hand, the employer has an implied right within the limits imposed by industrial relations laws, to direct and control the work of an employee. This is because the employee is working in the employer's business and the owner of a business has the right (within the confines of applicable law) to manage that business as the owner sees fit.

In Zuijs v. Wirth Brothers Pty Ltd [F15] the High Court articulated the significance of control in an employment relationship in the following way: [F16] 'What matters is lawful authority to command so far as there is scope for it. And there must always be some room for it, if only in incidental or collateral matters.'

Where the substance of a contract is to achieve a specified result, there is a strong (but not conclusive) indication that the contract is one for services. In World Book (Australia) Pty Ltd v. FC of T [F17] Sheller JA said: 'Undertaking the production of a given result has been considered to be a mark, if not the mark, of an independent contractor.' [F18]

In a contract for services, the contract specifies the services to be performed in return for an agreed payment. Satisfactory completion of the specified services is the 'result' for which the parties have bargained. Conversely, under a contract of service, payment is not necessarily (but may be) dependent on, and referable to, the completion of specified services.

Therefore, while the notion of 'payment for a result' is expected in a contract for services, it is not necessarily inconsistent with a contract of service, for example, in contracts for commission only sales. [F19] Accordingly, the other terms of the contract must still be considered in order to determine the true character of the contract.

An unlimited power to delegate work (with or without the approval of the service requirer) is an important indication that the service provider is an independent contractor. [F20] Under a contract for services, the emphasis is on performance of the agreed services (achievement of the 'result'). Unless the contract expressly requires the service provider personally to perform the contracted services, that person may arrange for his or her employee(s) to perform all or some of the work or may subcontract all or some of the work to another service provider.

The notion of the payer not requiring the payee personally to perform any work at all under the contract is contrary to the employment concept of a person working in the service of another. However, delegation clauses are considered in the context of the contract as a whole, to determine if they are consistent with the apparent essence of the contract or if they are merely self-serving statements.

Where the worker bears little or no risk of the costs arising out of injury or defect in carrying out his or her work, he or she is more likely to be an employee.

The higher the degree to which a worker is exposed to the risk of commercial loss (and the chance of commercial profit) the more he or she is likely to be regarded as being independent. Typically, a worker who derives piece rate payments and sustains large outgoings would be so exposed.

The higher the proportion of the gross income which the worker is required to expend in deriving that income, and the more substantial the assets which the worker brings to his or her tasks, the more likely it is that the contract is for services. [F21]

Some conditions of engagement are intimately associated with employment and may, therefore, be persuasive indicators. For example: • provision of benefits such as annual, sick, and long service leave; • superannuation contributions; • provision of other benefits prescribed under an award for employees; • where the worker uses assets and materials provided by the payer or is reimbursed, or is paid a compensatory allowance, for expenses incurred in respect of using their own assets and materials; and • where there is a payer discretion (within the constraints of industrial relations laws) in respect of task allocation and termination of engagement.

However, this list is not exhaustive and it must be emphasised that there is not a standard set of conditions applicable to an employee and a different set of conditions applicable to an independent contractor. Also, most conditions of engagement, when viewed individually, are equivocal as indicators of the true character of the contract.

In Montreal v. Montreal Locomotive Works [F22] Lord Wright said: '... it is in some cases possible to decide the issue by raising as the crucial question whose business is it, or in other words by asking whether the party is carrying on the business, in the sense of carrying it on for himself or on his own behalf and not merely for a superior.' Similarly, in Stevenson, Jordan and Harrison Ltd v. MacDonald and Evans [F23] Denning LJ said: '... under a contract of service, a man is employed as part of the business, and his work is done as an integral part of the business; whereas, under a contract for services, his work, although done for the business, is not integrated into it but is only accessory to it.'

From these statements, the notion of an 'integration' test (or organisation test as it is sometimes called) arose. While the factor is not determinative, this underlying distinction drawn between an employee and an independent contractor may be a useful aid or reference point in determining the status of a worker, i.e., is the worker working on his or her own account (independent contractor) or in the service of the payer (employee)? [F24]

However, the notion of integration has not been endorsed by Australian Courts. [F25] Nevertheless, the Courts have been prepared to use the concept as an ancillary check to reinforce conclusions based on the lawful authority to command concept. [F26]

Therefore, integration should not to be viewed as an alternative test, but rather as another relevant consideration to be taken into account in conjunction with lawful authority to command and other relevant factors.

Attachment B sets out a summary of the key indicators and illustrates the different application of these indicators to a contract of service and a contract for services .

The Commissioner cannot give a private binding ruling on the issue of whether a withholding is required to be made in the sense provided for by Part IVAA of the TAA because those provisions do not apply to tax collection matters. While the Commissioner, in accordance with Taxation Ruling IT 2500, will treat as administratively binding his opinions on such matters as the application of the PAYG provisions, such opinions do not give rise to objection, review and appeal rights provided in respect of Part IVAA rulings. [F27]

The only avenue of judicial review prior to the commencement of enforcement action is the declaratory writ process instituted in a court of appropriate jurisdiction. Otherwise, a person dissatisfied with the opinion of the Commissioner must wait until enforcement action is instituted - either prosecution or imposition of 'failure to withhold' penalties. In the case of 'failure to withhold penalties', the Commissioner has a general discretion to remit the penalty and general interest charge in whole or in part.

This Ruling applies to years commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

Below is a detailed contents list for this Ruling: Paragraph What this Ruling is about 1 Class of person/arrangement 1 Background 2 Ruling and explanations 8 Payments to employees - section 12-35 8 Payments made to persons other than individuals 11 Has the payment been made to an individual as an employee, of that or another entity? 16 Who is an 'employee' within the ordinary meaning of that expression 17 Background 17 Other types of contract 19 Common law 21 Terms and the circumstances of the formation of the contract 23 Key indicators of whether a contract is 'of service' or 'for services' 27 Control 28 'Results' contracts 32 Power to delegate 35 Risk 37 Conditions of engagement 40 Working on one's own account or in the business of the payer? - the so called 'integration' test 42 Private 'rulings' and enforcement procedures 47 Date of effect 49 Detailed contents list 50 Your comments 51

We invite you to comment on this Draft Taxation ruling. We are allowing 6 weeks for comment before we finalise the Ruling. If you want your comments to be considered, please provide them to us within this period. Comments by Date: 21 April 2000 Contact Officer: Stuart Dunlop E-Mail address: stuart.dunlop@ato.gov.au Telephone: (07) 3213 8578 Facsimile: (07) 3213 8858 Address: PO Box 9990 Chermside QLD 4032